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Rumors have been spreading across trading floors that the Fed may lower the penalty for using its dollar liquidity swap line to reduce stress in the interbank market. As I mentioned in a previous note, a 100bp ‘penalty’ over the overnight indexed swap (OIS) rate for the Fed’s dollar liquidity swap line is preventing the tool from impacting interbank borrowing risks as LIBOR continues to climb. The OIS rate currently stands at 0.22%, which means anyone utilizing the Fed’s swap program would be paying 1.22%, well above the current 3M USD LIBOR rate of 0.54%, leading to the programs ineffectiveness. In fact, the ECB’s most recent offering for the program on May 19th lacked even a single taker. If market speculation pans out and the Fed reduces the penalty spread to 50bps from 100bps, then the borrowing cost would fall to 0.72%–below the Fed’s discount rate of 0.75%–, but still remain well above current LIBOR levels meaning the impact could be minimal.

Next week the Fed will cease purchasing agency MBS, to an industry outsider this innocuous sounding fact may not garner much attention, but the reality is the implications are likely very significant, and are already making themselves apparent in the market. Former Fed Chairman Alan Greenspan recently referred to last week’s jump in U.S. interest rates as a ‘canary in a mine’ towards further increments in the future. Mr. Greenspan’s fears stem from the federal government’s massive–unprecedented–deficit, which is not a U.S. exclusive phenomena. Outside of the U.S. I expect pressure will be put on rates from the U.K. to Japan, with Japan (debt to GDP approaching 200%) being the most susceptible to a loss in investor confidence over the short-term as it rolls over a significant amount of debt on a very near-term basis.

Source: Bloomberg

But, I digress back to the Fed. Since the start of 2009 the Fed has begun purchasing up to $1.25trn of Agency MBS securities, these purchases have helped keep interest rates low and combined with the first time home buyer tax credit stoked pretty solid gains in home sales through November of 2009. However, since then an extension to the first time home buyer tax credit has proved itself impotent in stirring new demand, and next week as the Fed stops purchasing MBS, mortgage rates will likely continue on last week’s upward trajectory, putting any housing recovery into further jeopardy. To help show the correlation between mortgage rates and the Fed’s MBS purchases I created the chart below. The chart shows the 4wk moving average of the net change of the Fed’s MBS position, overlaid with 30Y mortgage rights:

Source: Bloomberg

As the chart demonstrates, when the Fed’s purchases of MBS goes up, rates go down; and as their purchases go down rates generally go up. I continue to expect that as a result of the termination of the Fed’s MBS purchase program 30Y mortgage rates will likely rise anywhere in the vicinity of 25 to 50 basis points, which could be further exacerbated by rising treasury yields. Rising rates will put further strains on a stalling housing recovery, and may force the Fed to reinitialize the program, or come up with another means of supporting the real estate sector. However, as I mentioned in the beginning of this entry, the bigger story over the months ahead could lie in U.S. and international rates markets, where risks may not be properly priced in given weakening fundamentals, partially due to Keynesian policy responses to the recent crisis. On that note, I expect we will see 10Y treasuries yielding above 4% (to as high as 4.5%) over the short-term, and as for Japan and some of the other troubled European nations, beware.

Economists and investors alike are speculating that the Fed could announce a second hike to the discount rate, after increasing its spread over the fed funds target rate to 50bps–compared to its historical level of 100bps. Some investors, despite Fed comments to the contrary, perceived the move as prelude to more significant tightening, be it through a reversal of quantitative easing and/or eventual rate hikes. Further adjustments could have a similar psychological effect on investors, especially given expectations that the Fed could remove or alter the phrase ‘extended period’ from its statement as early as April’s meeting–a clear sign tightening is quickly approaching.

Fed Funds Target (white) Vs. Discount Rate (orange):

According to the latest Federal Funds Implied Probability data, calculated by Bloomberg, the vast majority of investors anticipate no changes to the Fed’s target in April, but looking further out that number diminishes to 66.5% in June. In an environment of high unemployment, subdued inflation, and what could be tepid growth, I expect August would be the earliest we could expect a Fed rate hike. Nevertheless, news of another discount rate hike will almost certainly reverberate through the markets, spooking some skittish investors.

This week I am going to keep a close eye on several housing reports, which include January’s new (Wed) and existing (Fri) home sales along with December’s Case Shiller HPI (Tue)–December is the first month after what would have been the expiration of the first time home buyer tax credit. December’s home prices likely came under continued pressure, while January’s home sales data should show at least a modest bounce after their sharp declines in December stemming from the would-be expiration of the tax credit.

I will also be watching a slew of manufacturing releases including three regional Fed surveys–together these surveys can provide some insight on the month’s ISM–and the durable goods orders report (Thu). I anticipate that all should be positive excluding the Richmond Fed survey.

This week’s biggest news will likely culminate in a flurry of Fed speeches culminating with Chairman Bernanke’s semi-annual monetary policy report to Congress (Wed). But, given his recent House testimony, coupled with the FOMC minutes he may not have many surprises left to deliver in this week’s testimony. Nevertheless, markets will be keeping a very close eye on what he has to say, and any comments related to the timing of tightening will likely impact the market. There are also several other key important Fed speeches this week that could drive some headlines.

It looks like over the short-term the Fed will be using interest on excess reserves as its primary monetary policy tool to aid in its removal of excess liquidity from the market. This is the interest rates paid to banks on excess reserves held at the Fed. These comments continue to indicate accommodative monetary policy for the foreseeable future, but have set out a blue print on how eventual tightening will likely start to occur.

According to CNBC, James Bullard,President Federal Reserve Bank of St. Louis, indicated in an interview today that *he does not believe the Fed will begin hiking interest rates, until after they start selling off some assets. He anticipates that the Fed could begin selling assets during the second half of this year. Bullard had this to say on asset sales, “Maybe you get in the second half of 2010 or something like that, if things are going pretty well, maybe then you’d sell a little bit at that point and you’d try to see how the market reacts.”

In investors’ minds Bullard’s comments will likely reduce the probability of a near-term rate hike, and also help define the parameters for future hikes. I presently do not anticipate that we will see a Fed rate hike until November 2010 at the absolute earliest.

*I heard this reported on CNBC, but have not yet found the quote to support this statement.

As expected the Fed announced no changes to the target range for the federal funds rate, which currently stands at between 0% and 0.25%. The market was trading up prior to the announcement on what was generally expected to be a more constructive economic outlook from the Fed. In fact the Fed did seem more optimistic on the economic outlook stating that “Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out.” They go on to say that they believe conditions will continue to improve, and that their current monetary policy stance will remain in place for an extended period of time. They also announced, as expected, that the Fed will begin to slow and eventually stop purchasing US treasuries come October.

FOMC Statement:

Press Release

Federal Reserve Press Release

Release Date: August 12, 2009

For immediate release

Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

Back in January I did a piece discussing the predictive power of the Senior Loan Officer Survey, and found that there was some significance to the data. For the survey banks’ senior loan officers are asked to answer multiple questions based on their lending standards and demand for commercial/residential loans as well as consumer loans. The survey is conducted during the first month of the applicable quarter. (i.e. Q108 data is collected during Jan. 2008) This more or less implies the data has a forward looking aspect, since the applicable quarter has only begun when the data is collected. This data is reviewed by the Federal Reserve for conducting monetary policy.

Unfortunately, the October 2008 survey doesn’t look much better than it did back in January. Lending standards have continued to tighten and demand has diminished. Currently, the survey concurs with the view that US economy is in a recession, which shows no immediate signs of abating. Here is a quick outline on where the survey can be important in analyzing future trends:Non-residential Investment:We found that the strongest relationship exists between non-residential investment and the data in the survey related to the number of banks tightening lending standards to businesses , businesses’ demand for lending, and the cost of lending. In fact, the correlation between this data and non-residential investment is strong enough to pass-through to overall real GDP growth, but as you would expect with a smaller magnitude. We found that the reason for the relationship is because the level of business lending drops when costs and lending standards increase and demand drops, all of which are measured in the survey. Presently, all of these indicators point towards continued deterioration of non-residential investment.

Residential Investment:We also found that the lending standards and demand for mortgages data is correlated with residential investment, although not at the same significance as business lending with non-residential investment. We found the strongest result between residential mortgage demand and residential investment, but unlike the non-residential relationship it was not strong enough to pass-through to overall real GDP growth. Nonetheless, without a loosing in lending standards it is unlikely we can see a sustained recovery in the US housing sector.

Personal Consumption Expenditure:Unfortunately, historically we did not find any significant relationships. However, there has never been an instance over the available time series where credit card and consumer loan lending standards have increased by the magnitude we are currently experiencing. With this said, I do expect this to continue having a negative impact on consumer spending.

Notes: This graph would imply a continued slowdown for non-residential investment. Also interesting to note but not represented in this data is that many banks not only increased lending standards, but also reduced the maximum size and maturities on loans to all sized of businesses.

Notes: This graph implies that demand for business loans has not collapsed bu has shown signs of slowing. This is likely due to businesses requiring less credit to finance equipment, plant, and inventory expansions: Again pointing to a slow down in the business sector.

Commercial Real Estate Market

Notes: This graph implies there could be further deterioration in the commercial real estate market.

Notes: This graph implies tighter lending standards for credit cards and consumer loans could have an adverse effect on consumer spending. I agree with this assumption and do not see US GDP growth to move above trend until post 2010, mostly due to a decrease on consumer spending.

All in all in my opinion the implications of this survey are that things will get worse before they get better. Not only are tough times at hand for consumers, but also for businesses and the real estate sector. Over the next couple months, I expect we will see disappointing holiday sales, which should lead to lower than currently anticipated 4Q08 earnings and a prolonged period of below trend economic growth. This will likely continue to stoke the current volatility we have seen in the worlds’ financial markets.

One could argue we have moved from an age of exuberance to an age of despondency. Not long ago our major concern was sky rocketing commodity prices, and its effect on global inflation; enter the credit crisis. We are currently witnessing an unprecedented global sell-off with no regards to asset classes or quality, or as I like to call it the age of despondency. We have achieved capitulation. One positive result of this is this action is that it was a necessary step to bring us out of these uncertain times. In the end we should establish a clear bottom, and eventually stage a sustained comeback. Important to highlight is that in this age of despondency many assets, regardless of quality, have been pulled down to interim lows. For example right now, you can purchase the 30 stocks that make-up the Dow and receive a 3.8% dividend, plus of course any appreciation or depreciation of the assets. I won’t even begin to get into the credit market…

Looking ahead, what will happen? Global governments have made it clear they are willing to take significant action to stem the adverse effects of this current crisis. However, markets have been acting faster than these governments can react. Nonetheless, it is important to keep in mind that government and especially monetary policy tend to work on a lag. We still have not realized the effects of the recent rates cuts, and more importantly the Troubled Assets Relief Program (TARP). It is extremely likely we will see an additional set of global rate cuts sometime in the near future. This despite the fact the real effect of these cuts won’t be immediately realized, nonetheless, the psychological effect will be immediate. And of course, given the unbiased sell-off across all assets and qualities, investor psychology has definitely played a major role in this sell-off.

I believe that current and potential future government/monetary policies will eventually lead to stabilization in global markets over the next couple months. Prior to this however we face what could be a volatile earnings season, poor holiday sales in the US, and what will likely be worsening economic news from the US and Europe. Also, downgrades to either Morgan Stanley or Goldman Sachs could significantly extend the current market uncertainty, and this should be monitored closely. Nevertheless, unlike developed nations which are facing both the credit crisis and an economic slowdown, for the most part emerging markets are only facing the latter. What does this mean? I believe that once markets stabilize Russia, China, & Brazil will likely benefit the most over the mid-term. These markets are all significantly off their highs, yet domestically are still experiencing relatively strong GDP growth. What we want to monitor in these markets is the ability of domestic demand to make-up for slowing export markets. As for the developed nations, especially the US, there will be a critical shift from what were major consumers to major savers; given the importance of consumption in these economies we will likely see Real GDP growth remain below trend through the rest of this decade.

Here are some basic trading ideas, however, these are only suggestions; I in no way advocate undertaking them. I personally am hesitant to make any moves until I see some easing in the credit markets and proof that the TARP and other policies have begun to unlock credit markets… There is without question some great values out there on an individual equity basis, but the real question is whether or not you have the capital to stay in the market for as long as the market remains irrational…

Cash:Overweight Cash! (at least until we see the credit markets stabilize)

These are very interesting times… At this point in time, after passing up some deals which could have saved AIG, I wouldn’t be surprised if we saw at least part if not all of AIG being bought at bargain basement prices by one of its major competitors. I think it will be tough for them to find financing any other way, especially after the recent downgrades. However, I haven’t been following the industry too carefully, so it would be tough for me to speculate on an appropriate suitor (list could include ING, Allianz, AXA, etc…). Nonetheless, I am rather glad I haven’t taken on any new long positions in the sector recently. Something else we should all be paying close attention to is the effect these failures have on the CDS market, this could open up a whole new bag of worms. I recently read an article which stated that PIMCO alone currently guarantees USD760mn of AIG debt.

As for the Fed, I would be surprised, but not shocked, if we saw the Fed move 50bps today, however they will almost certainly switch to an easing bias in the statement and very likely modify and extend some of the current lending schemes (i.e. changes to the discount window and/or TAF, accepting more assets as collateral, possibly even allowing the Fed funds rate to trade well below target over the next couple of weeks, etc…). I don’t really believe a rate cut would be the right course of action, liquidity is the issue not price. However, psychologically it may help the market. All in all the Fed’s announcement will likely bring some calm to the market, which could easily be undone by an AIG collapse. We will all get a much better idea within the next 24 hours, as it has been reported an AIG deal would need to be completed by Wednesday. Currently, I am staying on the sidelines, but monitoring the situation closely. Finally, I did notice that the financial sector ultrashortETF is trading nowhere near its July highs, which I found somewhat interesting. I am not very familiar with this fund, so if anyone has some insight on this please feel free to email me.

As an aside, and as I mentioned was a possibility in my previous post, China has begun easing monetary policy. This could be an important factor once the market does start recovering. Many of China’s issues were self-inflicted and reversing policy could have a big impact as investors (eventually) become a bit less risk adverse.

UltraShort Financials ProShares (AMEX:SKF)

Contact Me:

Michael.McDonough@fiateconomics.com
Michael is an economist/strategist who has worked from Wall Street to Hong Kong primarily focusing on the U.S. and emerging markets. He has also written several columns. More

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